Analyzing Financial Statements, Part 1
Originally published: 04.01.07 by Ruth King
Ten ratios that will keep your company on track.
During my first visit to a contractor, he proudly showed me his financial statements. Being young and not as tactful as I hope I am now, I said, "You call those financial statements?" Quite frankly, I don't remember saying it. However, many years later, this contractor told me what I had said, so I probably said it.
The good news is that, even though he probably was shocked at the time, he knew enough to know that he had a lot to learn about what should be in, and how to read financial statements. This contractor, with my hep, became one of the most successful and profitable contractors in this industry, and we still keep in touch 18 years later. He was like most contractors — a contractor. He depended upon and understood the need for accurate blueprints to properly install equipment, but hadn't yet learned to depend on accurate financial statements to properly run his business.
Unfortunately, many contractors pay more attention to blueprints than financial statements. Why? Because reading blueprints is easy for them. Reading financial statements also can be easy, it just takes practice and a willingness to learn.
To make good business decisions in your company, you must analyze your financial statements each month. The financial statements are your scorecard. They tell you whether your company is healthy or needs some work to get healthy.
In this two part column, I'll describe 10 ratios that can help you analyze your business. I'll describe where to look to make sure the information in each ratio is accurate, how to calculate the ratio, what the ratio tells you, and what actions you should take if the ratio is not what it should be.
It is important to compute these financial ratios on a monthly basis, because the trends are as important as the specific monthly figures. You can spot trends and help your company avert a potential crisis by examining these ratios each month. To successfully spot trends, however, you must get timely financial statements each month.
Getting April's financial statement in June is too late — by then you've lost the ability to take action to avert problems because they've probably already appeared. So, please get your financial statements by the 15th of each month. The ratios are derived from your balance sheet and income statement.
The income statement tells you how profitable the company is each month, year-to-date, and potentially year-to-year. Your balance sheet is a snapshot of the health of your company. It tells you whether you have enough cash to pay your bills, if you are running out of cash, whether your inventory is getting out of control, or whether your debt level is too high.
While your income statement tells you whether your day-to-day jobs are providing profit, your balance sheet takes a longer view and lets you know whether you have enough cash to operate or whether you are heading for financial problems that you might not see on a daily basis.
These 10 ratios are the most critical to determining how your business is doing. They may not be the ratios that your banker uses to determine whether to approve your loan application. In fact, most bankers won't know what some of them, such as percentage compensation, mean. (Imagine being able to explain something to your banker!)
If these ratios are within normal ranges, however, then the ratios that the bank uses will be in normal ranges too.
The current ratio is a measure of liquidity, or how easily the company can pay its bills. You calculate this ratio by using figures from the balance sheet.
Current Assets /Current Liabilities
For safety, this ratio should be 1.8 or greater: The higher the ratio the better. Current assets are assets that are cash or can be turned into cash within a year such as accounts receivable and inventory. Current liabilities are debts that the company must pay within a year. They include accounts payable, lines of credit, taxes payable, service-agreement deferred income, and the current portion of long-term debt, such as one year's principal of a three-year truck loan.
When examining the balance sheet, make sure the assets and liabilities appear in the proper locations. Only include current assets that are really current assets. Make sure that property, buildings, loans to officers, and the like are listed as long-term assets rather than as current assets. If you have borrowed money from the company, then a receivable is showing on your balance sheet.
Be realistic, are you going to pay it back within a year? If not, then do not show this receivable in current assets. Likewise, make sure to include only current liabilities: those that will be paid within one year. If you have two- or three-year service agreements, only those service agreements that renew in the current year should be put in current liabilities. Others should go into long-term liabilities.
Make sure that long-term debt is not listed in current-liability categories. If the company owes you money, is it going to pay you back within the year? If not, then put it in long-term debt. If there are figures included as current assets or liabilities that should not be in those categories, subtract them out before calculating the current ratio.
Likewise, if there are figures that should be included in current assets or liabilities, add them in before calculating the current ratio. If you find that your current ratio is decreasing on a month-to-month basis, the first place to look is at job profitability. A low or falling current ratio usually is a sign that your jobs are not profitable or that your field employees are not productive.
Another reason that the current ratio might decrease is that you purchased assets, such as a truck or equipment, with cash. In this case, you have traded current assets for long-term assets while your liabilities stayed the same.
Acid Test or Quick Ratio
The acid test also is a measure of liquidity. You calculate this ratio by using figures from the balance sheet.
Current Assets — Inventory/Current Liabilities
For safety, this ratio should be 0.9 or better. If it is the same as the current ratio, then you are not including an inventory figure on your balance sheet. And, in the contracting business, most companies have inventory. Even though commercial oriented businesses have less inventory than residentially focused companies, they still have at least refrigerant inventory on their trucks.
The only time that a company wouldn't have inventory is when a parts supplier has placed parts on consignment in a contractor's shop and trucks. The acid test tells you whether you have too much cash tied up in inventory. Bankers know that even though inventory is a current asset, you often don't use it within a year. As a result, they want to know whether your company still can pay its bills without relying on selling inventory.
If the acid test is decreasing on a month-to-month basis, the same issue exists as when the current ratio is decreasing on a month-to-month basis. Look at the profitability of your jobs and make sure that your pricing is consistent.
Current Ratio to Acid Test
Look at the relationship between the current ratio and the acid test. If the ratio is greater than 2.0 (for example, if your current ratio is 3 and your acid test is 1), then you have too much money tied up in inventory. The only time inventory may be at such a high level is at the beginning of the busy season.
If it isn't, then either the inventory figure is incorrectly calculated (when was the last time the company took a physical inventory?), or the company must reduce its inventory level and use parts in the warehouse rather than going to the parts supply house when parts are needed. If the inventory is outdated, then it should be written off to reflect the actual inventory levels (your accountant can help).
Again, remember to include everything that is current assets in the current-asset total, and everything that is current liabilities in the current-liabilities total (see current ratio for a detailed explanation).